Liabilities not checked by asset growth
Growth of institutional pension fund assets in the 11 major markets measured in local currencies reached around 17% in 2005 and assets now total $16.4trn (€12.8trn). However, despite this significant growth, up from around 7% in 2004, pension fund liabilities also increased by approximately 9% on average in local currency terms, leading to an improvement in national funding positions of around 8%.
While this is a positive development compared with falls of around 30% between 1999 and 2002, the estimated asset/liability position globally is still about 20% weaker than in January 2000 despite three consecutive years of balance sheet strengthening.
The growth of pension fund assets has been rapid and according to our research total pensions fund assets in all the main markets, apart from the US and Japan, have doubled in size during the past 10 years. Certain countries have grown their assets more rapidly than others and the 10-year growth figure in Australia, a market that is dominated by defined contribuition (DC) assets, has reached 268%. Ireland has also seen remarkable growth in the past 10 years, which was helped along in 2001 with the establishment of its National Pensions Reserve Fund.
During the past few years the proportion of equity assets (both defined benefit (DB) and DC) have increased strongly in response to rising equity markets. Although this trend continues there has been increasing interest in bonds and alternative assets and bonds and the proportion of pension funds now invested in global equities has dropped to 58%, with bond assets accounting for 28%.
Going forward, this trend is expected to continue as the proportion of the population moving into retirement increases and DB funds mature as a result. It is also anticipated that there will be a continued growth in the allocation to alternative assets such as property and private equity as investors seek to diversify out of equities into a wider range of alternatives.
Another development of note is the growth of DC assets globally. The share of DC assets is now around 25% of total pension assets and has been increasing at a rate of close to 1% a year. It has been interesting to watch this growth in various countries, particularly Australia where strong government support in various forms, including legislation for mandatory contributions, has helped improve pension provision for their citizens.
Other countries can learn valuable DC lessons from these examples, such as the importance of member education and the management of cost and choice in provider-led marketplaces.
The growth of assets has helped the gradual strengthening of local pension fund balance sheets, with Japan experiencing the largest improvement in its asset/liability ratio, followed closely by Australia (although DB assets are now relatively small in this market). As a result of this strengthening, Japan is now ahead of its relative 1998 funding position, along with only Canada and Australia.
However, despite these improvements liabilities have remained stubbornly high. While assets have clawed back some lost ground in the last three years, liabilities are likely to continue to increase because of mortality improvement. As a result, the global balance sheet is likely to remain in a delicate state for the foreseeable future, a situation that will not be helped by their inherent volatility caused by the still high allocations to equities.
This ‘risky’ state of the global pension balance sheet was illustrated in the first quarter of this year. Large falls in bond yields during January more than reversed in February and March. The average funding level finished higher overall but the swings in these levels were considerable.
This type of experience brings into sharp focus the effect of closer measurement of pension liabilities as well as the need for prudent management of risk, if workplace pensions are to survive in their current form.
While the evidence indicates some improvement within the balance sheet position of many countries, the news on pensions is unlikely to improve substantially in the medium term. Liabilities are likely to increase in value in response to the continued improvement of mortality amongst many retirees, in addition to the more stringent valuation methods being imposed upon many funds around the globe.
The pensions funding conundrum is likely to be less reliant on asset class movements going forward and will depend to a greater extent on increasing company contributions. Given these trends, decision-makers within companies are concluding that they do not want to bear the cost of babyboomers’ retirements on their balance sheets, and so defined benefit schemes around the world will continue to close.
Liabilities can be measured on a number of different bases. In our analysis we have used long government bond discount rates to make global comparisons easier. These figures will not coincide with measures used in accounting where AA bonds are generally used, or the measures used for funding purposes where rates usually take some account of the expected returns from equities.
Roger Urwin is the global head of investment consulting at Watson Wyatt